Good, albeit not grand, U.S. economic data inched up slowly but surely

Russia/Ukraine tensions and the resulting sanctions having a spillover effect on the fragile European economy

We continue to maintain our positions favoring equities over fixed income, growth over value, small-cap over large-cap, and U.S. over global

Our current outlook
Matters haven't changed much on the U.S. economic front over the past month. Growth continues to chug—sometimes even grind—along a slow but still optimistic "I think I can, I think I can," pace, reminiscent of that plucky Little Engine that Could.

The Investment Strategy Team (IST) had its monthly meeting last week to discuss its weightings and outlook.¹ Our view is that, having shaken off the volatility from the first half of the year, the economy seems poised to generate relatively consistent growth in the 2.5% – 3.0% range over the next several quarters. Recent data continue to support the economic picture but, in keeping with our outlook for relatively modest growth, the information has not been overly strong.

A slight July decline in auto sales of about 600,000 units is a dot on the overall landscape which has shown consumers still willing to buy big-ticket items. Retail sales inched up 0.1% but previous months were revised higher, bringing the overall level of sales up from those earlier estimates. Good news on the employment front, with job gains in nonfarm payrolls above 200,000 per month and an increase in those seeking work, which signals growing confidence in the availability of employment. Against this backdrop, we think the Fed will not raise short-term rates before mid-2015.

We are concerned that tensions as a result of the Russia/Ukraine conflict are pressuring an already-fragile European recovery and could keep the U.S. economy from picking up steam. German economic growth slipped into negative territory in the second quarter as the impacts from Russian sanctions hurt the closely tied German economy. We view this conflict as the biggest threat and source of uncertainty in our current outlook.

Another concern is the European Central Bank (ECB) and its recent mostly unsuccessful efforts to stimulate growth. The unification of the banking system has yet to take place, leaving the industry still dealing with capital constraints and regulatory uncertainties that have made lending difficult. Businesses have been unwilling to borrow given the continued prospects of slow growth. The ECB may take on a quantitative easing (QE) program, but has so far taken few steps in this direction. The central bank has stated that it is trying to gauge the effectiveness of the programs put in place last June. Without this, yields seem likely to stay low and perhaps drift down further, keeping deflation threats elevated and the prospect of growth a challenging one. From a market perspective, the IST sees that the introduction of a QE program may, similar to what happened in the U.S. and in Japan, spark a fairly significant rebound in asset prices which could lead to developed international markets well outperforming our own market.

Affirming our positions
While not making any changes, the IST did review its various positions and affirmed current allocations. Our overall outlook for the U.S. economy provides key support to the prospect of positive if muted equity returns and our view that stocks will continue to outperform bonds. Through August 18, the Russell 3000 had gained 7.8% year-to-date while the Barclays Aggregate Index had returned 4.5%. As we look ahead, we are concerned that market returns will have difficulty matching the rate of gains seen thus far in 2014. For equity markets, the recent rejection of price-to-earnings multiple expansion points out how dependent future gains will be on earnings growth. Fixed income markets will likely face headwinds from some modest interest rate normalization as we get closer to the prospective shift in Fed policy.

We are retaining several allocation positions that have recently struggled. The market's June retreat from risk caused our allocations to growth over value and small-cap over large-cap to perform poorly. Last month, the IST reviewed these positions and made no further changes. In the interim, the market's growing comfort with higher-risk assets has enabled our positions to rebound somewhat.

Our view that the U.S. economy is performing better than most other developed parts of the globe reinforces our very slight overweight to U.S. markets. This position will be watched carefully, particularly if the ECB should decide to initiate QE and hostilities between Russia and Ukraine back down enough for sanctions to be removed. With near-deflationary trends in parts of the developed world and U.S. labor markets still experiencing slack conditions, we remain comfortable with our underweight to inflation hedges.

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